By: Luigi Marinus, Portfolio Manager at PPS Investments

Where have we come from?

In March this year, the last of the three major global ratings agencies, Moody's, lowered South Africa's credit rating to sub-investment grade. As a result, South African bonds would be excluded from the FTSE World Government Bond Index (WGBI). 

The downgrade occurred around the time that lockdowns were starting to be enforced in many countries across the globe. Bond yields, especially in emerging markets, experienced a sharp increase as the ability of these economies to maintain production levels during lockdown came into question. The effect in South Africa was that longer dated sovereign nominal bond yields moved into double digits and sovereign inflation-linked bonds real yields rose above 5% at the long end. At the same time emerging market currencies, including the rand, weakened as well. It meant that when the anticipated Moody’s downgrade was eventually announced, most of the damage in the bond market had already occurred and yields hardly moved when the news broke.

The sentiment at the time was one of inevitability as both S&P and Fitch had previously downgraded South Africa to sub-investment grade and the ability of the government to improve the country’s fiscal situation was further complicated by the lockdown.

What effect is the latest downgrade likely to have?

When South African credit was downgraded in March it was a definitive line in the sand that meant that debt was no longer investment grade. In the most recent downgrade by Moody’s and Fitch, the debt rating dropped a further notch deeper into sub-investment grade. Moody’s which was the last of the three major rating agencies to drop South African debt to sub-investment grade moved to a Ba2 rating, shifting South African debt to two notches from investment grade. Fitch moved the South African rating to BB- which is three notches from investment grade. S&P maintained their rating at BB-, also three notches from investment grade. In addition to the Moody’s and Fitch downgrades, they have both maintained their negative outlook for South African debt. 

In general, a downgrade indicates that the ability of an issuer to service existing or new debt has declined and an increase in bond yields together with a depreciation of the currency are expected. Even though the timing of these downgrades were largely unexpected by the market there was very little change to yields or the exchange rate in the subsequent trading days. There is a strong argument to be made that this further downgrade was largely priced into bond yields.

A comparison of yields in countries with a similar credit rating is one of the best ways to assess this. Brazil, another emerging market economy has a BB- S&P rating, a BB- Fitch rating and a Ba2 Moody’s rating. These are the same ratings by each of the ratings agencies as South Africa, post the recent downgrade. In April of this year as yields first increased as a result of lockdowns, the yield on the South African 10-year government bond was 10.4%, while the yield on the Brazilian 10-year government bond was 7.9%, even though South African debt, at the time, was rated one notch higher by both Moody’s and Fitch. At the end of October, the yield on the Brazilian bond was again 7.9%, while the yield on the South African bond had declined to 9.2%. Since the end of October and post the South African debt downgrade these yields have hardly moved and South African 10-year government debt still offers roughly 1% more yield per annum than the Brazilian equivalent, even though the ratings are aligned. While this may not be the only way to assess a bond valuation, it suggests that South African bonds are cheap on a peer relative basis and that a downgrade was already priced in.

Has this shifted our portfolio positioning?

At PPS Investments, we remain confident in the ability of the South African government to service its bond debt. Our portfolios maintain the maximum overweight position to domestic bonds so that investors can benefit from the attractive yields, especially as inflation has remained subdued and cash rates have declined significantly over the year. This does not imply that South African bonds offer no risk, nor that yields must decline to Brazilian bond levels. The sizable inflation-beating level of return is similar to the risk premium historically earned by domestic equities leading us to believe that on a risk-adjusted basis domestic bonds remains a sound investment.

Downgrades are an uncomfortable realisation that debt concerns are increasing but may provide an investment opportunity when perceived risks are overpriced. In a well-diversified portfolio where risk is considered at a total fund level, this additional yield can add significant value when held at the appropriate exposure and with other domestic and global asset classes.